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CHAPTER

4

Measuring Cash Flows

a firm keeps spending more cash than it generates, it will eventually run into f trouble. Thus, the ability of managers to make decisions that generate cash over time is essential to a firm's long-term survival. Making profits will help, but only if those profits can be quickly converted into cash. The firm's suppliers, its bankers, and the tax authorities require payment in cash, not profits. The road to business success is cluttered with bankrupt firms that were actually showing a profit in their last published income statement. Statistics for most developed countries indicate that almost four out of five firms that went bankrupt were actually profitable; they died from a lack of cash, not from meager profits. There are two categories of cash flow: cash inflows, which are the number of dollars that come into the firm, and cash outflows, which are the number of dollars that go out of the firm. A successful value-creating manager must have a clear understanding of how these cash flows are measured, what their sources are, and how they should be managed. This chapter presents a general framework for analyzing cash flows and their relation to business decisions. We first construct a preliminary cash-flow statement based on the firm's three fundamental activities: operating, investing, and financing activities. Next, we show how to use the firm's balance sheets and income statements to measure the cash flows generated by each of these activities during the accounting period. We then put all the information together in a detailed cash-flow statement. Finally, we present alternative methods for calculating cash flows that are often used by firms in presenting their cash-flow statements. As in Chapter 3, OS Distributors' financial statements for the years 2003, 2004, and 2005 are used to illustrate the analysis. After reading this chapter, you should understand the following: • • • The relationship between cash and cash flows The relationship between profit and cash flows How business decisions affect cash flows

I

114

FINANCE

FOR

EXECUTIVES

How to use a firm's balance sheets and income statements to calculate the cash flows generated by the firm's operating, investing, and financing activities How to prepare and interpret a cash-flow statement

Cash Flows and Their Sources

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The amount of cash held by a firm at a particular time is found on the asset side of its balance sheet. OS Distributors' balance sheets in Exhibit 4.1 show the firm had $6 million in cash at the end of 2003, $12 million at the end of 2004, and $8 million at the end of 2005. If total net cash flow is the difference between the total amount of dollars received (cash inflows) and the total amount of dollars paid out (cash outflows) over a period of time, we can easily find OS Distributors' total net cash flow in 2004 and 2005. Each time OS Distributors received a dollar, its cash account increased by a dollar; each time it spent a dollar, its cash account decreased by a dollar. The amount of cash held by OS Distributors increased from $6 million to $12 million between December 31, 2003, and December 31, 2004. Therefore, during 2004, its activities must have generated a positive total net cash flow of $6 million, the difference between $12 million and $6 million. During 2005, the firm generated a negative total net cash flow of $4 million, because cash decreased from $12 million to $8 million during that year. Thus, a firm's total net cash flow is equal to the change in the firm's cash position during a period of time. Total net cash flow, which accounts for all the transactions the firm undertakes during a period of time, is, unfortunately, too broad a measure of a firm's net cash flow to be a useful indicator of the firm's ability to generate a surplus of cash over time. We want to know the particular activities that have contributed to an improvement and the particular activities that have contributed to a deterioration in the firm's cash position during a given period of time. For example, we want to identify activities associated with the following transactions: the firm receives cash from a customer (a cash inflow resulting from an operating activity); the firm purchases some new equipment (a cash outflow resulting from an investment decision); or the firm borrows from its bank (a cash inflow resulting from a financing decision). Each of these transactions wiII cause a change in the firm's cash position. In general, a firm's cash position will change as a result of decisions related to three separate types of activities: (1) operating activities, (2) investment activities, and (3) financing activities. These activities are usually both a source of cash inflows and a source of cash outflows. Exhibit 42 shows typical transactions associated with each of these activities. The upper part of the exhibit presents the sources of cash inflow, and the lower part presents the sources of cash outflow from these transactions. Each type of activity generates a net cash flow. The net cash flow for operating activities is called net operating cash flow (NOCF); for investing activities, net cash flow from investing activities; and for financing activities, net cash flow from financing activities. Each type of activity is related to a specific section of the firm's managerial balance sheet, which was introduced in Chapter 3. Operating activities, and thus NOCF; are associated with the

C HAP T E R 4

Measuring Cash Flows

115

December 31.

2005

Current assets Cash' Accounts receivable Inventories Prepaid expenses'' Total current assets

$

6.0 44.0 52.0 2.0 104.0 0.0

$ 12.0 48.0 57.0 2.0 119.0 0.0 $90.0 (39.0) 51.0 51.0 $170.0 $93.0 (40.0)

$

8.0 56.0 72.0 1.0 137.0 0.0 53.0 53.0

Noncurrent assets Financial assets and intangibles Property, plant, and equipment Gross value" Less; Accumulated depreciation Total noncurrent assets

$90.0 (34.0)

56.0 56.0 $160.0

Total assets Liabilities and owners' equity • Current liabilities Short-term debt Owed to banks Current portion of long-term debt Accounts payable Accrued expenses+ Total current liabilities • Noncurrent liabilities Long-term debtS Total noncurrent liabilities • Owners'equity6

$190.0

$ 15.0 $ 7.0 8.0 37.0 2.0 54.0 $ 42.0 42.0 64.0 $160.0 $14.0 8.0

$ 22.0 $15.0 8.0 40.0
__1:Q

$ 23.0 48.0 4.0 75.0 38.0 38.0 77.0 $190.0

66.0 34.0 34.0 70.0 $170.0

Total liabilities and owners' equity

'Consists of cash in hand and checking accounts held to facilitate operating activities. 2Prepaid expenses is rent paid in advance (when recognized in the income statement, rent is included in selling, general, and administrative expenses). 31n2004. there was no disposal of existing fixed assets or acquisition of new fixed assets. However. during 2005. a warehouse was enlarged at a cost of $12 million. and existing fixed assets, bought for $9 million in the past. were sold at their net book value of $2 million. 'Accrued expenses consist of wages and taxes payable. SLong-term debt is repaid at the rate of $8 million per year. No new long-term debt was incurred during 2004. but during 2005 a mortgage loan was obtained from the bank to finance the extension of a warehouse (see Note 3). . "During the three years, no new shares were issued. and none was repurchased.

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~.~~~--~----------------------------FINANCE FOR EXECUTIVES

1 16

Operating activities
• Sale of goods and services

Investing activities

Financing activities
• Issuance of stocks and bonds • Long-term borrowings • Short-term borrowings

Operating activities
• Purchase of supplies • Selling, general, and administrative expenses • Tax expense • • • • •

Financing activities
Repurchase of stocks and bonds Repayment of long-term debt Repayment of short-term debt Interest payment Dividend payment

Net cash flow from operating activities $11.2

Net cash flow from investing activities ($10)

Net cash flow from financing activities ($5.2)

firm's working capital requirement, which is the difference between its operating assets (its receivables, inventories, and prepaid expenses) and its operating liabilities (its payables and accrued expenses). Investment activities are associated with net fixed assets.' Financing decisions are associated with the entire funding side of the managerial balance sheet, called capital employed. We explain how to calculate the cash-flow amounts shown in Exhibit 4.2 in the next sections.

INet fixed assets include long-term financial assets that are considered a part of the firm's "investing activities." Cash inflows occur when long-term financial assets are sold, interest and dividend income are collected, and long-term loans, which were extended by the firm to outsiders, are repaid. Cash outflows occur when long-term financial assets are purchased and long-term loans are made to outsiders.

2005 'Cash on January 1. that is. and financing activities absorbed $5. net operating cash flow.4). See balance sheets in Exhibit 4.1. investing and financing cash flows-are derived from the firm's balance sheets at year-end 2003.1). is the same as cash on December 31. are shown in Exhibit 4. The statement breaks down the change in the firm's cash position according to its operating. 2004. investing. Investment activities absorbed $10 million of cash. The sources of cash inflow and outflow are those identified in Exhibit 4.2 million ($472 million less $460. and 2005 and its income statements for the years 2004 and 2005. As shown in Exhibit 4.2. is equal to $11. This deficit was financed by taking $4 million from OS Distributors' cash account.2 million in net profit (see OS Distributors' income statements in Exhibit 4.2. and the amounts of the three components of OS Distributors total net cash flow-operating. .8 million). OS Distributors "lost" $4 million in cash but generated $10. leaving OS Distributors with a cash deficit of $4 million for the year ($11. 2005.2 million.2 million).2004. Preparing a Detailed Cash-Flow Statement Detailed cash-flow statements for OS Distributors for the two years ending December 31.1). 2004.2005. Notice that there is no obvious relationship between total net cash flow and net profit (earnings after tax) ofthe same year. its operations generated a cash inflow of $472 million and a cash outflow of $460. leaving the firm with $8 million in cash at the end of 2005 (see Exhibit 4.2 million less $10 million less $5.5. The firm began the year with $12 million in cash (see Exhibit 4. net cash flow from operating activities. and financing activities.2. using the information in Exhibit 4.C HAP T E R 4 Measuring Cash Flows 117 Net operating cash flow (NOCF) + Net cash flow from investment decisions + Net cash flow from financing decisions Total net cash flow for year 2005 Cash on December 31. and December 31.8 million. Hence. In 2005. The next sections explain how these cash flows are calculated. ($4) Exhibit 4.3 shows a preliminary cash-flow statement for OS Distributors for 2005.

0 24. and depreciation and tax expenses. Operating revenues are net sales.118 FINANCE FOR EXECUTIVES • Net sales Cost of goods sold Gross profit Selling.0 67.4). NET CASH FLOW FROM OPERATING ACTIVITIES Net cash flow from operating activities. or net operating cash flow (NOCF).0 'There is no interest income. The balance sheet at the beginning of 2003 is not available.0 8.5 11.0 17. However.0 $ 6.0 $ $ 8.0 39.2 $ 7. and administrative expenses Depreciation expenses Operating profit Extraordinary items Earnings before interest and tax (EBIT) Net interest expenses' Earnings before tax (EBT) Income tax expense Earnings after tax (EAT) Dividends Addition to retained earnings $390.0 24.7 4.2 5. SO net interest expenses are equal to interest expenses.0 $ 3.3 5. we need an income statement for that year and two balance sheets.Cash outflow from operations The sources of operating cash flows are the operating revenues and expenses in the income statement (see Exhibit 4. so a cash-flow statement for OS Distributors for 2003 cannot be prepared. general. one at the beginning of the year (the same as the one at the end of the previous year) and the other at the end of the year. To prepare a cash-flow statement for a given year.2 • $ 5.7 5.0 13. selling.0 $ $ 10.3 $480.0 400.0 2.0 18. is simply the net cash flow originating from the firm's operating activities during the period under consideration: Net operating cash flow (NOCF) = Cash inflow from operations .3 0.0 328.0 62.0 7.0 0. not all these revenues or .0 353.0 17.0 6. and administrative expenses.0 18. general.2 0.0 43.3 5.8 5.7 $420. and operating expenses are the sum of cost of goods sold.0 80.0 2.8 • • • • • $ 7.0 17.0 48.

0) ($8.0 (8. Net cash flow from investing activities CasllfloW~·frorn .0 $ 8.0) (6.0 7. Furthermore. There is no one to whom the firm pays depreciation.0 C.0) (43.0) (7.0 (8. . Thus. Closing cash (E + D) 'Excluding depreciation expenses expenses generate or consume cash. an increase in revenues does not necessarily imply a corresponding cash inflow.0 (400.0 $480. Thus. not when they are paid.3) (4.fill~nCil1gacti"ities (+) (+) (-) (-) (-) Increase in long-term borrowings Increase in short-term borrowings Long-term debt repaid Interest payments Dividend payments 0. revenues are shown in the income statement only when recognized..0 $12. Expenses are recorded only when they generate a corresponding revenue. that is.8) (14.0 (353. net cash flow (A + eTC) E.0 12.0) $12. when customers are invoiced. an increase in expenses 2When a fixed asset is acquired. A typical example is depreciation.2) ($5..0) $14. Net cash flow from financing activities Total.2 Net operating cash flow (NOCF) Casllflow$.0) ($10.0) (2. ~r-tiviti~~ (+) Sale of fixed assets (-) Capital expenditures and acquisitions 0.frorri in"". not when cash changes hands.activities (+) Net sales (-) Cost of goods sold (-) Selling.7) (5. they are not recorded as such in the income statement.0) $11. general.0 2. depreciation is excluded from the calculation of net operating cash flow.0 $0. there is a cash outflow equal to the acquisition price of the asset.. even though revenues and expenses eventually end up as cash inflows or outflows.C fI APT E R 4 Measuring Cash Flows 119 Cash·flows..foin. the firm no longer experiences any cash movements related to the purchase of the asset. Opening cash F.0) (48.0 0.0) (3.0 $6. and administrative expenses' (-) Tax expense (-) Change in working capital requirement $420.s Consequently.0 (12.0 1.0) (5. As discussed in Chapter 2..0) B.0) $6. When that asset is subsequently depreciated over a period of time.2) ($4. from· operating .

general.COGS . COGS is cost of goods sold.uAccounts receivable where uAccounts receivable is the change in receivables during the estimation period. the accountant records the transaction by increasing the firm's cash account and decreasing its accounts receivable by the amount paid. At that time. as shown in Appendix 4. We can write the following: Accounts receivable. Each time a customer is invoiced. the cash inflow from sales is less than the sales revenue during that period of time.SG&A expenses . SG&A expenses is selling.aWCR (4.1. The firm's operations generate revenues and expenses that are recorded in the income statement and . the cash flows that originate from the sale of goods and services.1.Cash inflow from sales Rearranging the terms of the above equation gives us this: Cash inflow from sales = Sales . How then can we measure the cash flows from operating revenues and operating expenses? We first consider the cash inflows from operations. is a very simple formula for obtaining the net operating cash flow from balance sheet and income statement accounts: NOCF = Sales .1. = Accounts receivablebeginning Sales + . The result. which. and u WCR is the change in working capital requirement. by following what happens to receivables over a period of time. we can estimate the cash inflow from sales during that period.[Accounts receivable. Therefore. Let's consider an intuitive interpretation of equation 4. The procedure for estimating the cash inflow from sales can be applied to all the operating expenses that involve cash transactions.1) where NOCF is net operating cash flow. the key to higher cash inflow from sales is a faster collection of accounts receivable.j. Cash comes in later when the customer pays. Hence. by definition.j.Tax expenses . When accounts receivable increase during a period of time (uAccounts receivable positive). the related cash outflow is obtained by adjusting the dollar amount of an income statement account with the change in the corresponding balance sheet account during the period. When they decrease (uAccounts receivable negative). given a target level of sales. the firm's accountant records the sale by increasing both the firm's net sales account and its accounts receivable by the amount of the sale. .120 FINANCE FOR EXECUTIVES does not necessarily imply a corresponding cash outflow.Accounts receivablebeginning] This equation can be written as follows: Cash inflow from sales = Sales . the corresponding cash inflow from sales is more than the sales revenue during that period of time. and administrative expenses. But the balance sheet accounts used for the adjustments are exclusively those related to the firm's operating cycle. receivables increase each time a sale is made and decrease each time a bill is paid. are the accounts that make up its working capital requirement. Starting at the beginning of the period. As shown in Appendix 4.

0 $126.(Accounts payable + Accrued expenses).0 $42.0 70.$4 million = $14. Because this cash is unavailable to the firm. the change in the amount of cash paid for inventories.0 77.0 $38.$5.0 106. and the change in the amount of cash the firm owes its suppliers and other: creditors. That is.0 $34. 2005 Invested capital or net assets Cash Working capital requirement (WCR)l • Net fixed assets • • $ 6.0 59.0 104.3 million .$63 million LlWCR2005 = WCRl2!31!05 = $14 million Using equation 4.$400 million .0 Total invested capital or net assets $121.II APT E R 4 Measuring Cash Flows 121 captured by the first four terms on the right side of the equation.7 million .$353 million .1 and the data in the income statements in Exhibit 4.0 $ 12. the increase in working capital requirement (Ll CR) represents the W amount of cash the firm has used to finance the growth of its investment in operations.$6.4. which reproduce the managerial balance sheets of OS Distributors presented in Chapter 3.$59 million $4 million = $77 million .6.0 63.0 Total capital employed 'WCR = (Accounts receivable + Inventories + Prepaid expenses) .0 $ 8.8 million . we can compute the change in OS Distributors' working capital requirement in 2004 and 2005 as follows: Ll CR2OO4 W = = WCR12/31!04 - WCR12!31103 WCR12/31104 = $63 million .0 $138.0 115.0 56. These activities require an investment in the firm's operating cycle that is recorded in the balance sheet and that is measured by the change in working capital requirement during the period.0 51.0 $121. Working capital requirement changes with the change in the amount of cash due to the firm by its customers. Using the data in Exhibit 4.2 million OS Distributors' All data from the of dollars December 31. we can now calculate the firm's net operating cash flow in 2004 and 2005: NOCF2004 = $420 million .0 · Capital employed • Short-term debt Long-term financing Long-term debt Owners' equity $ 15.$48 million . .0 77.0 $ 22.0 53.0 64.0 $ 23. 2003 December 31.$43.0 million NOCF2OO5 == $480 million .$14 million == $11.0 $126. it reduces its operating cash flow.0 --$138.

and the lower its tax bill will be. the $4 million increase in WCR represented less than 30 percent of NOCF. and amortization.1 as well as in equation 4. calculated using equation 4.WCR 3. and administrative expenses (SG&A).COGS . because interest payments are tax deductible.3 million . For OS Distributors. Because earnings before interest and tax (EBIT) is equal to sales less the sum of cost of goods sold (COGS).3 we get this: NOCF = EBITDA .$5.S14 million = $11.Tax expenses .122 FINANCE FOR EXECUTIVES The upper part of Exhibit 4. However.1 or 4.l.2) Replacing the "Sales . which we examine in a later section. More precisely. and thus are affected by all the taxable transactions incurred by the firms. Note the contribution of the change in working capital requirement to net operating cash flow in the two years.5 presents OS Distributors' net operating cash flow for 2004 and 2005. we have the following: NOCF2OO1 NOCF2OO5 = $18. or EBDIT. For example. and tax.3 when analyzing a firm's operating cash flows. Such an adjustment is made in the definition of another well-known measure of cash flow.2 is equal to earnings before interest.SG&A expenses" in equation 4. .8 million . in 2005.. Net operating cash flow can also be computed using a different approach.COGS .3 million + $5 million .$4 million = $14." we get this: NOCF = EBIT + Depreciation expenses .1. it represented more than 120 percent of NOCE In other words. known as EBITDA. most analysts and corporate finance managers still use NOCF as defined in equation 4. the more interest payments it will have to make.1 with "EBIT plus depreciation expenses. A more precise measure of the cash flow generated by a firm's operating activities would ignore the tax effect of financing decisions.Tax expenses - aWCR (4. not only those related to its operations. the tax expenses in these two equations are affected by the firm's decision to have more or less debt financing.3 Replacing EBIT plus depreciation by EBITDA in equation 4.3) Note that in equation 4. tax. NOCF is indirectly affected by the firm's financing decision. the more debt the firm carries.3 can be obtained by noting that "EBIT plus depreciation" in equation 4. In 2004.2 million A compact version of equation 4. the free cash flow.0 million = $24 million + $8 million .$6. we can write the following: EBIT + Depreciation expenses = Sales . the decrease in net operating cash flow that OS Distributors experienced in 2005 compared with 2004 was mostly caused by the growth of its investment in operations that was required to support growing sales.4). tax expenses are taken directly from the income tax account in the firm's income statement.-\n alternative expression for EBITDA is earnings before depreciation. general.3. depreciation.SG&A expenses (4. In other words. interest. and depreciation expenses (see Exhibit 4. selling.

These gains or losses are accounted for in the income statement and affect the firm's earnings after tax.4) OS Distributors had no fixed assets acquisitions or disposals during 2004. EBITDA is equal to $23.4 is the net book value of the assets. If the sale price is different. firms usually provide supplementary information in the form of notes to their financial statements from which it is possible to estimate the cash flows related to the firm's investing activities during the accounting period. Because OS Distributors does not hold any long-term financial assets.C HAP T E R 4 Measuring Cash FloLVs 123 For OS Distributors.1 explains that the firm did not sell or acquire fixed assets during 2004. Note that over a period of time these accounts increase when the firm acquires fixed assets and decrease when the firm deducts depreciation expenses and sells fixed assets. NET CASH FLOW FROM INVESTING ACTIVITIES The firm's investments during the accounting period are not directly reported in its balance sheet or income statement. . Note 3 at the bottom of OS Distributor's balance sheets in Exhibit 4. As a result. For example.$5 million .Depreciation expenses . The net effect of the firm's investment decisions is a net cash flow of zero in 2004 and $10 million in 2005. Fortunately. Net fixed assets12/31104 = $56 million + $0 . sold $2 million of old assets. We can check that the net fixed assets accounts in the balance sheets are consistent with this information. and the 2003 balance sheet indicates net fixed assets at the end of 2003 as $56 million.3 million plus $5 million) and $32 million in 2005 ($24 million plus $8 million). Given that net fixed assets at the end of 2004 were $51 million. They are shown in the second part of the cash-flow statement in Exhibit 4.$8 million = . a warehouse was enlarged at a cost of $12 million and existing assets were sold at their book value of $2 million. However. the difference is either an extraordinary gain (the sale price is higher than the net book value) or an extraordinary loss (the asset is sold at a lower price than the net book value). The balance sheet reports only the net book value of all the firm's fixed assets. OS Distributors acquired $12 million of new assets. In 2005.5. and the income statement reports only the depreciation expenses for the accounting period.$2 million $53 millions 4The value of disposed assets in equation 4. during 2005. The 2004 income statement shows depreciation expenses of $5 million.$0 = $51 million This is the same amount of net fixed assets reported in the balance sheet at the end of 2004. we have the following: Net fixed assetsl2/31105 = $51 million + $12 million . Thus Net fixed assetsend = Net fixed assetsbeginning Fixed assets acquisitions + .Fixed assets disposals (4.3 million in 2004 ($18. and had depreciation expenses of $8 million. the cash flows from its investing activities are related only to the acquisition and disposal of fixed assets.

During the same period. We can use the data from OS Distributors' balance sheets in Exhibit 4.2 million.6. and the firm continued to repay $8 million of its existing long-term debt (Note 5).2 million minus $10 million). as shown in Exhibit 4. They are reported for OS Distributors in the third part of the detailed cash-flow statement shown in Exhibit 4. net cash flow from financing activities was a negative $8 million in 2004 and a negative $5.2.4 to identify and calculate the cash flows related to its financing decisions in 2004 and 2005. but free cash flow has several alternative definitions. The firm's long-term debt increased by the $12 million borrowed to finance the extension of its warehouse (Note 5). and financing activities during a period of time. from $14 million to $15 million.2 million in 2005 ($11.s In total.5. . Some will add cash to the firm. it repaid $8 million of its long-term debt (Note 5). the firm increased its short-term borrowings by $7 million. This measure of cash flow is often called free cash flow. whereas others will absorb cash. so we prefer to refer to the sum of net cash flows from operating and investing activities as net cash flow from assets. short-term borrowings increased by $1 million. the firm paid its interest expenses and its dividends for the year. Interest payments were $7 million. In 2004. At the end of both years (2004 and 2(05). The 2004 income statement shows that the firm paid $5 million in interest and $2 million in dividends. These are the assets reported on the upper part of the managerial balance sheet shown in Exhibit 4. and dividend payments amounted to $3. The remaining portion of a firm's total net cash flow is the cash flow from its financing activities. as shown by the increase in its short-term bank debt from $7 million to $14 million during that year. NET CASH FLOW FROM FINANCING ACTIVITIES A firm can carry out a large number of financing transactions. Recall that this net cash flow must be equal to the firm's change in its cash position during the 5Interest and dividend payments are equal to the figures shown in the income statements because OS Distributors does not have any accrued interest payable or accrued dividend payable. Exhibit 4.5. This cash flow corresponds to the capital employed shown in the managerial balance sheet. Net cash flow from assets is the cash flow generated by the firm's invested capital. In 2005.5 indicates that OS Distributors' net cash flow from assets was $14 million in 2004 ($14 million plus zero) and $1. The most frequently reported transactions are presented in Exhibit 4. investing.124 FINANCE FOR EXECUTIVES Net Cash Flow from Assets The sum of the net cash flows from operating and investment activities is a measure of the net cash flow generated by the firm's invested capital or net assets.2 million in 2005.1 and the data from its income statements in Exhibit 4. THE CASH-FLOW STATEMENT The firm's total net cash flow is the balance of the firm's cash flows related to its operating.

95 in November 1987 titled "statement of cash flows. in that order. During 2004.5. This is the amount of cash shown in the firm's balance sheet at year-end 2003 in Exhibit 4. there was a total net cash outflow of $4 million (operations generated $11. thus. This information is already available in the balance sheets given in Exhibit 4. with the cash-flow statements in Exhibit 4. as shown in line E of the cash-flow statement in Exhibit 4. It tells which of the firm's decisions have generated cash and which have absorbed cash. If this is the case. the statement of cash flows provides information on cash flows related to operating. Hence. organizations in charge of developing accounting standards. so its cash position at the end of 2004 was $12 million. investing activities absorbed $10 million. which presents OS Distributors' statement of cash flows.1. total net cash flow is $6 million in 2004 ($12 million less $6 million) and a negative $4 million in 2005 ($8 million less $12 million). OS Distributors' cash position was $6 million at the end of 2003. its total net cash flow was $6 million." Like the cash-flow statement presented in the previous section. operations generated a net operating cash flow of $14 million (line A). $12 million at the end of 2004.2 million). the sum of the initial $6 million and the additional $6 million generated during the year (line F). so it ended the year with $8 million.S. and financing activities. However. The Financial Accounting Standards Board (FASB). and its financing activities absorbed $8 million of cash (line C). and financing activities absorbed $5. Its cash position was $6 million at the beginning of the year. A sequence of historical cash-flow statements indicates whether and how a firm's cash flow is improving or deteriorating and.5).5. the way these cash flows are calculated and the aIIocation of cash flows to these three activities are somewhat different. investing. what is the usefulness of a cash-flow statement? The cash-flow statement tells how and why the firm's cash position has changed during a particular period of time. Note that OS Distributors' cash-flow statements are not needed to learn that the firm generated $6 million in cash in 2004 and consumed $4 million in 2005. and $8 million at the end of 2005. as can be seen by comparing Exhibit 4. . THE STATEMENT TO FASB 95 OF CASH FLOW ACCORDING Firms are required by regulatory authorities to provide a statement of cash flows that classifies the firm's cash flows differently from the cash-flow statement we have presented (Exhibit 4. During 2005. the difference between $14 million and $8 million (line D). The firm made noinvestments in 2004 (line B). Hence. The firm's cash position at the beginning of 2004 was $6 million. This is the amount shown in the firm's balance sheet at the same date. OS Distributors began the year with $12 million in cash. the initial $12 million less the $4 million consumed during the year. issued Standard No. We can now reconcile the cash flows from OS Distributors' activities in 2004 and 2005 with the changes in its cash position during these two years.1. one of the major U.II APT E R 4 Measuring Cash Flows 125 period.2 million. whether the firm is in a sound financial position or heading toward troubled times.7.

Net cash flow from financing activities O." The indirect method of presenting cash flows cash has been criticized by many accounting professionals. in our approach. as Exhibit 4.0 $0.0) $4.0) $9.8) ($4.0 C.0 (8.0) ($3. are part of the firm's financing activities.5. . Net cash from investing activities • Cash flows from financing activities (+) Increase in long-term borrowings (+) Increase in short-term borrowings (-) Long-term debt repaid (-) Dividend payments 0. the firm's operating activities include interest expenses. which was used in the cash-flow statements in Exhibit 4. cash receipts and cash disbursements related to operating activities are reported directly and separately.0 (12.0 $10.2 A.126 FINANCE FOR EXECUTIVES 2004 • 2005 • Cash flows from operating activities (+) Earnings after tax (+) Depreciation expenses (-) Change in working capital requirement $8.0) (3.0 (14.0 2. Opening cash F.0) ($10. it is estimated according to the indirect method. Net cash provided by operating activities • Cash flows from investing activities H Capital (+) Sale of fixed assets expenditures and acquisitions 0. First.5 in two ways.0 7.Total net cash flow (A+ B+ C) E.0 $8.0 1.0 (8. which. 6Under the alternative or direct method.0 0.0 5. Second.2 8.Closing cash (E + D) Cash Flows from Operating Activities The net cash flow provided by operating activities in the statement of cash flows differs from the net operating cash flow (NOCF) in Exhibit 4.0) (2.8 shows.0) $6. This method starts with earnings after tax and adjusts them for noncash items and transactions that are not related to the firm's operating activities.0 $6.0 12.2) ($1.0) $12.0 (4.0 $12.0) B.

2 million (see Exhibit 4. when FAS 95 established the standards for cash-flow reporting. the cash-flow methods may soon find their way to the table. who is also a member of FASB's advisory council. and changes in working capital accounts. Although both produce the same number.2 million is then adjusted by the $14 million change in the firm's working capital requirement. depreciation expenses of$8 million are added because these expenses are not cash-related items. The indirect method.ft APT E R 4 Measuring Cash Flows 127 Of all the recent financial-reporting reforms. FASB left the indirect method as an alternative. At a November [2004] conference hosted by Financial Executives International. an accounting professor at the Georgia Institute of Technology. "The single thing in my view that should go furthest toward improving disclosure" would be to mandate direct-method accounting. says Nusbaum. deferrals. accruals. The balance of $18. Still. Securities and Exchange Commission chief accountant Donald Nicholaisen thinks the most important has yet to be proposed: requiring companies to use the direct method to report their cash flow. as shown in . then. For OS Distributors in 2005. is whether analysts and other financial-statement users really want to make the change. Still. recalls Grant Thornton CEO Ed Nusbaum. 'This article was written by Tim Reaon and appeared in CFO in January 2005. Nicholaisen has never directly suggested that the SEC or FASB change the requirement.4). And since companies using the direct method must provide a reconciliation to net income using the indirect method anyway. "This is a back-burner item that is slowly moving forward. says Mulford. Back in 1987. and so on. by contrast. the indirect method had always been the method of choice for many companies. however. earnings after tax were $10. At the November conference. The direct method calculates operating cash flow as a product of actual cash flow in and out=-collection from customers. arrives at that figure by adjusting net income for noncash expenses (such as depreciation and amortization). "the indirect method can hide a multitude of sins. To date. he did remark that "there's more that we have to do. corporate efforts to improve reporting have "fallen short" of his expectations." The question. bowing to corporate concerns about the expense of tracking all cash items. cash payments to suppliers." says Mulford. it's no surprise that most simply continue to use the latter." says Charles Mulford. Nicolaisen said that despite Sarbanes-Oxley and the slew of new rules issued by the Financial Accounting Standard Board.

both lenders and shareholders.5. which is. It is the cash flow available to the suppliers of capital to the firm.Tax expenses related to the firm's operating activities -~WCR .7 and 4.Net capital expenditures Using the same approach that led to equation 4. From the definition of free cash flow.5.5 is $7 million ($11. before accounting for cash receipts and cash expenses from its financing activities. the firm's net interest expenses for 2005. The net cash flow from operating activities is thus $4. Another one is banker's cash flow or cash earnings. Because these items are already taken into account in the earnings after tax. we can rewrite free cash flow as this: Free cash flow = EBIT + Depreciation expenses .2 million less $4. Cash Flows from Investing and Financing Activities The cash flows related to investing and financing activities are reported in the statement of cash flows the same way they are presented in our cash-flow statement. The differences between the two variations of the cash-flow statement can be seen by comparing the statements in Exhibits 4. we can write the following: Free cash flow = Sales . not surprisingly. except (1) interest payments are not shown as a financing activity and (2) interest and dividends received from financial investments are not recorded as an investment activity. Net Operating Cash Flow Versus Free Cash Flow Versus Bankers' Cash Flow A popular measure of a firm's cash flow is free cash flow or cash flow from assets.2 million less $14 million).COGS .3. FREE CASH FLOW Free cash flow or cash flow from assets is defined as the total after-tax cash flow generated by a firm's invested capital.2 million).Tax expenses related to the firm's operating activities -~WCR . they are already included in the operating activities section of the statement. As shown in Chapter 6 and Chapter 12.128 FINANCE FOR EXECUTIVES Exhibit 4.2 million ($18.Net capital expenditures . The difference between this amount and the net operating cash flow in Exhibit 4. this particular feature makes free cash flow an important measure of performance in the valuation of investment projects and businesses.SG&A expenses .

6 million) can be explained by the net capital expenditures ($0 million in 2004 and $10 million in 2005). whereas in the net operating cash flows they apply to the firm's earnings before tax.5 to OS Distributors with the assumption that the firm's tax rate is 40 percent in 2004 and 2005 (the ratio of income tax expenses to earnings before tax in 2004 and 2005). and with data already used in the calculation of the firm's net operating cash flow and total net cash flow.8 million). First. The corresponding tax credit was $2 million (tax rate of 40 percent multipied by $5 million) in 2004 and $2. the difference being the tax savings generated from interest payments. then the tax expenses related to the firm's operating activities is simply Tc x EElT.. we get this: Free cash flow2oo4 = $18.$10 million = . BANKERS' CASH FLOW Bankers' cash flow or cash earnings is usually defined as the sum of earnings after tax (EAT) and depreciation expenses (other noncash items are also added if there are any): Bankers' cash flow = Earnings after tax (EAT) + Depreciation expenses (4. the difference is $2 million in 2004 ($0 million plus $2 million) and $12.40) = $12 million? + $5 million .3 shows that free cash flow differs from net operating cash flow on two accounts. comes from showing only one decimal rounding numbers in the income statement. OS Distributors paid $5 million in interest in 2004. as shown in the company's income statements. Factoring EBIT in the above equation gives us this: Free cash flow = EBIT x (1 .C HAP T E R 4 Measuring Cash Flows 129 Comparing this equation with equation 4.6) "The calculation shows that the exact amount is $11. Second. accounted for in the free cash flows. If T c is the corporate tax rate.$4 million . $. which reduce the firm's total tax bill. plus the tax credit provided by debt financing.~ WCR .T c) + Depreciation expenses .8 million in 2005 (tax rate of 40 percent multiplied by $7 million).$14 million . tax expenses in the free cash flow applies only to the operating profit.5) In this equation. .Tc) is often referred to as net operating profit after tax (NOPAT) or net operating profit less adjusted taxes (NOPLAT).98 million.6 million.3 million x (1 .02 million. and $7 million in 2005.$1.8 million in 2005 ($11.Net capital expenditures (4.40) + $8 million . The difference from the $12 million. whereas net operating cash flow does not.8 million in 2005 ($10 million plus $2.2 million plus $1.$0 Free cash flow2oo4 = $24 million x (1 . In total. free cash flow includes the net cash flow from capital expenditures. The difference between the firm's net operating cash flows and these free cash flows-$2 million in 2004 ($14 million less $12 million) and $12. Applying equation 4. the term EBIT x (1 ..

Bankers' cash flow. the firm's bankers' cash flow increases according to equation 4. Thus.Tax expenses Substituting for EAT in equation 4.Selling. bankers' cash flow and net operating cash flow are equivalent only when (1) there is no variation in the firm's working capital requirement (Il WCR = 0).6 cancels the depreciation expenses. Its net operating cash flow was $14 million in 2004 and $11. takes into account the fact that in 2005 the firm had to invest an additional $14 million in its operations (IlWCR = $14 million). But .2 million + $8 million Although net operating cash flow declined by 20 percent between 2004 and 2005 (decreasing from $14 million to $11. and administrative expenses .4: Earnings after tax (EAT) = Sales . its profits usually rise. and administrative expenses . What was its bankers' cash flow? Applying equation 4. We now have the following: Bankers' cash flow = Sales .5 to the data from OS Distributors' income statement (see Exhibit 4. Consequently. It ignores any balance sheet adjustments.130 FINANCE FOR EXECUTIVES Bankers' cash flow is derived exclusively from income statement accounts. This situation is unlikely.2 million = $10.6. When a firm experiences a period of rapid growth.7) Bankers' cash flow + Net interest expenses -Il WCR (4. bankers' cash flow is not really a measure of cash flow.Selling. Consider OS Distributors.2 million). behaves like a profit measure. general. Because income statement accounts are usually not cash-related accounts.Depreciation expenses . How does bankers' cash flow compare with net operating cash flow? From Exhibit 4.5). Net operating cash flow. general.2 million in 2005 (see Exhibit 4.8) where IlWCR is the change in the firm's working capital requirement.Cost of goods sold .Net interest expenses .Net interest expenses . bankers' cash flow rose by 40 percent during the same period.1 leads to the following: Net operating cash flow = (4. which ignores changes in the firm's working capital requirement. a true measure of cash flow. we get the following: Bankers' cash flow2004 Bankers' cash flOW2005 = $8 million + $5 million = $13 million = $18.7 and equation 4.Tax expenses Comparing equation 4.Cost of goods sold .4). and (2) net interest expenses are zero.

8 provides another method for estimating a firm's net operating cash flow: Start with bankers' cash flow. Managerial Implications Net operating cash flow. and the change in working capital requirement was $14 million.9 shows the two components of OS Distributors' net operating cash flow in 2004 and 2005. would decrease. and the margin component increased by 40 percent.3 percent between 2004 and 2005. Because the investment component of net operating cash flow grew much faster than its margin component.2 million plus $7 million less $14 million). and deduct the change in working capital requirement during the year. Finally. Exhibit 4. selling.2 million ($18. the firm's cash holding decreases. Sales grew by 14. The margin component is defined as sales less the sum of cost of goods sold (COGS).2 million. For OS Distributors in 2005. and administrative (SG&A) expenses. find itself in a difficult cash position.Investment component (4. If the performance of OS Distributors' managers is measured only in terms of their contribution to profits. their 2005 performance was remarkable. The investment component is the change in the firm's working capital requirement. This explains why a firm can show a hefty bankers' cash flow and. a year-to-year growth of 250 percent! The net result is not flattering for OS Distributors' operating cash flow. add the firm's net interest expenses. simultaneously. working capital requirement does as well. which is negatively related to changes in working capital requirement (see equation 4. providing the right signal: Sales growth has produced a corresponding growth in working capital requirement. which. managers had to increase investment in the firm's operating cycle (working capital requirement) from $4 million to $14 million. note that equation 4. As a result. net operating cash flow was equal to $11. Interest expenses were $7 miIIion. The implication is clear: If margin decisions are made without considering their effects on .1). the result may be disastrous for operating cash flow. However. as defined in equation 4.9) the finn s investment in its operating cycle. to generate this higher margin in 2005. the firm's net operating cash flow actually declined by 20 percent. can be written as a margin component less an investment component: Net operating cash flow = Margin component . in turn.C HAP T E R 4 Measuring Cash Flows 131 because sales also increase during a period of rapid growth. bankers' cash flow is $18. Hence.1. Managers need to be wary of the traditional bankers' cash flow as a measure of a firm's change in cash position. and tax expenses. general. Under the same circumstances-a period of rapid growth-net operating cash flow. is putting pressure on the firm's net operating cash flow.

and the acquisition of other businesses.0 ($4.0 ($14.9 indicates that firms should run and monitor their operating activities on the basis of net operating cash flow rather than margin." It has to make strategic investment and funding decisions to generate more cash than it consumes.0 77.2 40. Monitoring the performance of operating managers on the basis of their contribution to the growth of net operating cash flow will encourage them to widen the firm's margin without letting investment in operations (working capital requirement) grow too fast and offset the contribution of wider margin to the firm's operating cash flow. The various cash-flow statements presented in this chapter provide useful information about these decisions by showing how much money the firm has spent and how much money it has earned as a consequence of these decisions.0% .0) $11.0 $63.20. the purchase of equipment.3) $18. .132 FINANCE FOR EXECUTIVES 2004 Sales less COGS less SG&A expenses less tax expenses $420..0) $14.0 (353.2 250.0 63.0% = margin component Working capital requirement at the beginning of the year less working capital requirement at the end of the year $59.7) (5.0% = NOCF investment component = Margin'" Investment Equation 4.0 $25.. A firm can be viewed as a "cash machine. Strategic investment decisions include the building of plants.0) (43. Strategic funding decisions include long-term borrowing and the issuance of shares. The net effect will be a higher operating cash flow for the firm.

even though strategic decisions are the keys to the firm's long-term ability to create value. Thus. net operating cash flow equals earnings before interest and tax plus depreciation expenses less tax expenses and the change in the firm's working capital requirement. the change in working capital requirement represents the cash used to finance the growth in the firm's net investment in its operating cycle.3. excluding depreciation expenses). One distinguishes between cash flows generated from the firm's operating activities (its net operating cash flow). the investment component is the change in the firm's working capital requirement. and the change in the firm's working capital requirement. Firms generally use two types of cash-flow statements interchangeably. over time. The relevant measure of the cash flow generated by operations is net operating cash flow. In this formula. Another approach is given by equation 4.C II APT E R 4 Measuring Cash Flows 133 However. its investing activities. a noncash item). . Net operating cash flow can be defined as the difference between a margin component and an investment component. because bankers' cash flow ignores changes in working capital requirement and defines cash flow as the sum of net profit and depreciation expenses. It is the net cash flow generated by running the business. for example). One approach is given by equation 4. The margin component is the firm's operating margin (its sales less its operating expenses. that is.1. There are alternative approaches to calculating a firm's net operating cash flow. the weaker the firm's net operating cash flow. In this case. and its financing activities. The other one is the statement of cash flows recommended by the Financial Accounting Standards Board. efficient day-to-day management of the firm's operating cycle (the machine's "engine") can. they do not guarantee that the "machine" will permanently produce excess cash. Only good operating decisions. tax expenses. The more cash that goes to fund operations (to support additional inventories and receivables. For a firm with a rising (and positive) working capital requirement. net operating cash flow equals sales less operating expenses (excluding depreciation expenses. net operating cash flow is a better indicator of the ability of a firm to generate cash than the popular bankers' cash flow. help generate more cash than is consumed. not by selling some of its assets or borrowing from banks.

Thus.dAccounts receivable (A4.4. cash inflow from sales can be measured by tracing what happens to accounts receivable during the estimation period.1) where Mccounts receivable is the change in accounts receivable during the period. the cash inflow from sales is calculated using information from the period's income statement and from the opening and closing balance sheets that surround the income statement.1: Cash inflow from sales2OO5 = $480 million - $8 million = $472 million which is the amount reported in Exhibit 4. what is the cash inflow from sales for as Distributors in 2005? The balance sheets in Exhibit 4. as shown in the 2005 income statement in Exhibit 4.1 Obtaining the Net Operating Cash Flow From Balance Sheet and Income Statement Accounts et operating cash flow (NOCF) is defined as the difference between the cash inflow and the cash outflow from the firm's operating activities.2. .APPENDIX 4.$48 million = $8 million The 2005 sales are equal to $480 million. This cash inflow is equal to sales adjusted by the change in receivables during the period: Cash inflow from sales = Sales . respectively. Therefore dAccounts receivable2OO5 = $56 million . using the estimation of as Distributors' net operating cash flow in 2005 as an illustration. This appendix shows how these cash flows can be estimated from the balance sheets and income statement.1 show that accounts receivable at the end of 2004 and 2005 are equal to $48 million and $56 million. From equation A4. N MEASURING CASH INFLOW FROM OPERATIONS As shown in Chapter 4. For example.

we get Purchases = COGS + Mnventories (A4.2) where dAccounts payable is the change in payables during the estimation period. these costs are released to the cost of goods sold (COGS)account. For a distributor. We can write the following: Cash outflow from operations = Cash outflow from purchases + Cash outflow from SG&A and taxes Cash Outflow from Purchases To determine cash payments to suppliers. we use the same approach as the one used to calculate cash receipts from customers. + Rearranging the terms of the equation. we get the following: Cash outflow from purchases = Purchases . Instead of tracing what happens to receivables during the estimation period. purchases are not shown in the income statement. inventories at the beginning of the period increase by the cost of purchases made during the period. Thus.Cash outflow from purchases Rearranging the terms of the equation. Thus: Accounts payableend = Accounts payablebeginning Purchases + . for a distributor. unlike sales. .[Accounts payableend . accounts payable increase by the amount of the invoice. general.C HAP T E R 4 Measuring Cash Flows 135 MEASURING CASH OUTFLOW FROM OPERATIONS Cash outflow from operations includes payments to suppliers for purchased goods. If a distributor sells more goods than it buys during the accounting period. Equation A4. However. Each time the firm receives an invoice from one of its suppliers.Accounts payablebeginning] This equation can be written as Cash outflow from purchases = Purchases . excluding depreciation. the inventories account will increase by the difference. which is not a cash item. if the amount of goods purchased during the accounting period exceeds the amount of goods sold during that period. we trace what happens to payables. we can write the following: Inventoriesbeginning Purchases . and administrative (SG&A) expenses.j.3 could have been obtained directly because.dAccounts payable (A4. They must be computed indirectly from the data provided by the income statement and the balance sheets. and tax payments. When the firm sells the goods.COGS = Inventories. accounts payable decrease by the amount paid. and each time the firm pays an invoice.3) where Mnventories is the change in inventories during the period. the inventories account will decrease by the difference. cash expenses related to selling.

[$48 million . if ~Accrued expenses and ~Prepaid expenses represent the change in the accrued and prepaid expenses accounts.3 into equation A4.$4 million] = $53.1). rent payments as indicated in Note 2 to the balance sheet) was $1 million less than the expense reported in the income statement for 2005. when OS Distributors' prepaid expenses decreased by $1 million in 2005 (Exhibit 4.[$4 million .5) . the decrease would have been added to the expenses. OS Distributors' accrued expenses increased by $2 million. To convert operating expenses into cash payments. As a result.4) Using the data in OS Distributors' 2005 income statement and in the balance sheets at the end of 2004 and 2005. the cash outflow from the firm's operations in 2005 is Cash outflow from purchases 2005 = $400 million + [$72 million . The second term is the change in the inventories account in 2005. This means that cash paid for operating expenses (in this case.8 million (A4. payments for wages and tax. we get this: Cash outflow from SG&A and tax expenses2005 = $48 million + $6.$2 million] .~Accrued expenses Applying equation A4. Cash Outflow from SG&A and Tax Expenses To determine the amount of cash paid for selling. the decrease of $1 million must be deducted from the expenses. For example. In 2004. and administrative (SG&A) expenses and tax expenses during the estimation period. This approach is similar to adjusting purchases for changes in accounts payable to determine the cash payments to suppliers. Therefore. respectively. The third term is the change in accounts payable between year-end 2005 ($48 million) and year-end 2004 ($40 million).8 million + [$1 million . general.2 yields the following value for the firm's cash outflows from purchases: Cash outflow from purchases = COGS + Mnventories .5 to OS Distributors in 2005. we must adjust them for any change in prepaid expenses and accrued expenses.~Accounts payable (A4. the $2 million must be subtracted from operating expenses to arrive at the cash payment. the increase would have been added to the expenses.$57 million] .$40 million] = $407 million The first term on the right side of the equation is the cost of goods sold in 2005. If the accrued expenses had decreased. This is the difference between the inventories at year-end 2005 ($72 million) and year-end 2004 ($57 million). as indicated in Note 4 to the balance sheet) was $2 million lower than the expenses recorded in the 2004 income statement. we can write the following: Cash outflow from SG&A and tax expenses = SG&A expenses + Tax expenses + ~Prepaid expenses . If the prepaid expenses had increased.136 FINANCE FOR EXECUTIVES Substituting the value of purchases given by equation A4. cash paid for operating expenses (in this case.

1.LlAccrued expenses (A4.[LlAccounts Receivables + Lllnventories + LlPrepaid expenses .LlAccrued expenses] .4. we have Cash outflow from operations2oo5 [$400 million + $48 million + $6. we get the following: Cash outflow from operations = COGS + SG&A and tax expenses + Lllnventories + LlPrepaid expenses .LlAccrued expenses Rearranging the terms of the equation. We can now estimate net operating cash flow by finding the difference between cash inflow from operations. using data from the income statements and balance sheets in Exhibit 4.Tax expenses] .4.1 and 4. general.$2 million] .Mccounts payable .COGS . The terms in the second and third set of brackets are the changes in prepaid expenses and accrued expenses taken from the balance sheets at year-end 2004 and 2005 in Exhibit 4.4 to the cash outflow from selling.8 million = which is the amount shown in Exhibit 4.LlAccounts payable + SG&A and tax expenses + LlPrepaid expenses .1.LlAccrued expenses + LlAccounts payable] The terms in this equation can be rearranged to yield: NOCF = [Sales .[$4 million . equation A4.4. NET OPERATING CASH FLOW We can now derive a general formula for a firm's net operating cash flow. and cash outflow from operations. general. we get the total cash outflow from operations: Cash outflow from operations = COGS + Lllnventories .It APT E R 4 Measuring Cash Flows 137 The terms in the first set of brackets are the selling.8 million] + [$72 million .2.SG&A expenses .6: NOCF = [Sales -llAccounts receivable] .$57 million] + [$1 million . and administrative expenses and tax expenses in equation A4.[$48 million .6) For OS Distributors.[COGS + SG&A expenses + Tax expenses + Mnventories + LlPrepaid expenses . and administrative expenses and tax expenses from the 2005 income statement in Exhibit 4.LlAccounts payable . equation A4.$4 million] = $460.$40 million] . Adding the cash outflow from purchases in equation A4.

COGS .SG&A expenses . and the last two terms measure the changes in its operating liabilities. Recall that the difference between the firm's operating assets and its operating liabilities represents the accounting estimate of the firm's net investment in its operating cycle and is called working capital requirement (WCR).1.WCR. . Therefore.138 FINANCE FOR EXECUTIVES The first three items in the second set of brackets measure the changes in the firm's operating assets.WCR which is equation 4. or 6. the expression in the second set of brackets represents the change in the firm's working capital requirement.Tax expenses . Thus: NOCF = Sales .6.

158 million less $473. However.391 million plus $381. showing its margin and investment components. reproduced in Exhibit A4.841 million less $495. its investing activities. We can now reconstruct RI. should belong to the firm's financial activities.s net operating cash flow for fiscal years 2004 and 2005. we get interest expenses of $10 million in fiscal year 2004 and $6.s income statements.3. it is practically impossible to directly relate these two statements with the cash-flow statement. RI.9.232 million ($495.317 million in 2005.363 million less $18. respectively.317 million ($476.232 million) in fiscal year 2004 and $370.363 million ($6. From RI.158 million) in year 2005. one can. and its financing activitieshave contributed to the changes in its cash position over the two-year period.s investment in the operating cycle increased by $21.391 million in year 2005. Note that in this version of the cash flow statement.1. not to its operating activities. reproduced in Exhibit A4. and $388. The analysis of these statements will show us how the three main activities of the firm-its operating activities. because the FASB accounting board does not require firms to provide detailed information on the adjustments to be made to reconcile cash flows and income statements' or balance sheets' individual accounts. as in Exhibit 4.840 million ($223. P RESTRUCTURING RL'S CASH FLOW STATEMENTS The cash flow statements in Exhibit M. .972 million) in year 2005.1 were prepared according to Standard 95 of the Financial Accounting Standard Board (FASB 95).232 million in fiscal year 2004 and minus $18. Further. From Rl.2. which.046 million ($388.2.608 million plus $21.2.608 million in fiscal year 2004 ($10 million plus $213.2. circumvent these shortcomings using information from the firm's income statements and managerial balance sheets that we presented in Appendix 2 of Chapter 1 and Appendix 2 of Chapter 3.608 million). that is $244.2. that is $21. to some extent. The investment component is the change in working capital requirement. as we have already mentioned. The margin component is the net operating cash flow plus the investment component.926 million) in fiscal year 2004 and decreased by $18. the net cash flow provided by the operations includes interest expenses. Adding these amounts to the net cash provided by operating activities gives a net operating cash flow (NOCF) of $223. we can compute the change in the firm's working capital requirement over each year of the two-year period.Polo Ralph Lauren's Cash Flows aloRalph Lauren's cash-flow statements for fiscal years 2004 and 2005 taken from the firm's annual report on year 2005 are shown on Exhibit A4.317 million) in 2005.s managerial balance sheets.

608 million).459) (14.248) (417. In the following sections.729 343.547 381 (174.608 million in fiscal year 2004 to $388.847) (1.281 2. investing. we analyze the contribution of the firm's operating.046 million less $223. RL'S CASH FLOWS FROM OPERATING ACTIVITIES Rr:s net operating cash flow increased nearly 75 percent in fiscal year 2005.229 44. According to information provided in the annual report on fiscal year 2005.138) (243.414 (100.140 FINANCE FOR EXECUTIVES Net income Adjustments to reconcile net income to net cash provided by operating activities Net cash provided by opetatingactivities Cash flows from investing activities Purchases of property and equipment.250) 3.850) 352.379 213.003 $ 190.2.485 Exhibit A4.839 (12. net of cash acquired Others Net cash used in investing activities Cash flows from financing activities Payment of dividends Repurchase of common stock Proceeds from exercise of stock options Net payment of short-term debt Others Net cashprovided by finan9ingactivities $ 169.420 million in fiscal year 2004 to $27. this .363 million in 2005.606 (1.206 higher in 2005 than in 2004 ($370. This increase comes both from a significant improvement in the margin component. which was $125.386) (21.943) 6.052) 54.048) (134. from $223.564 o Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period 8. Note that the firm's total net cash flow changed from minus $84.425 191. net Acquisitions.053 33.608 (126.4 shows RI:s cash flow statements after adjusting for the above changes in the firm's operating cash flows.335 $ 350.335 $ 352. and financing activities to this drastic change.718) (1.047) 40.173 million in year 2005.

2004 April 2.761 107.305.391 Net interest expenses Earnings before tax (EBT) 276. 2003 April 3.841 million divided by $3.s 2005 annual report.649. and administrative Operating profit expenses 902.026 (2. was able to reduce this investment to 14.319 1.231.620.457 17.4 cents by the end of year 2005 ($476. 2005 $2.335 $3.869 1. As we saw in Appendix 2 of Chapter 3.654 million of revenues).248 million.141 263. which needed to invest 18.382.824 101.323. from $134.298 14.229 $ 190.C H APT ER 4 Measuring Cash Flows 141 March 29.158 million of working capital requirement divided by $2. generated $18. improvement results from higher gross margins.326 13.104 10.126) Extraordinary items' Earnings before interest 290.425 'fhe extraordinary items account includes the restructuring charge. which amounted to $243. particularly in the wholesale and retail businesses.386 million.326.232 million of cash in fiscal year 2004. .305.340 Cost of goods sold 1. general.336 Income tax expenses • Earnings after tax (EAT) $ 175. this reversal came from a better management of the operating cycle. of the firm's accounts receivable. We showed there that RL. which used $21.104 93. According to Rl.317 million of cash in year 2005. other (income) and charges reported in Rt.207.972 and tax (EBIT) 290.415 million).032. Most of the difference is attributable to acquisitions made during the year 2005.520 305. in particular.2 • Chapter 2).:s income statements (Exhibit A2.546 1.683 $ 169.654 1.7 cents in its operating cycle per dollar of revenue at the end of fiscal year 2004 ($495.353 302. RL'S CASH FLOWS FROM INVESTING ACTIVITIES RL spent much more on its investing activities in fiscal year 2005 than in year 2004.459 million to $417. The investment component.739 $2.875 297. and.303 1.000 304.502 273.152 6.439.649.415 1.862 1. most of this amount is attributable to the acquisition of a children's wear company.601 Selling.684.

414 million in 2004 and $54.208.158 944.886 $ 352. The annual report on fiscal year 2005 indicates that these shares will be used for stock option and employee ownership programs.149 million in fiscal year 2004 (net operating cash flow of $223.459 million of net spending on investing activities) and a cash flow deficit of $29.418 $1.859 $ 350.960 137. the currency of the company's debt.639. RL showed a cash-flow surplus of $89.841 1.475 $ 277.S.926 821.606 473.023 million in 2005 ($388.485 476.675.386 million). The deficit in 2005 resulted from the major acquisition made during the year.142 FINANCE FOR EXECUTIVES Invested capital • Cash • Working capital requirement • Net fixed assets $ 343.538.943 1.214 1.494 81.352 $ 2.S.933 Capital employed • Short-term debt • Long-term financing Long-term debt Other long-term liabilities Owners' equity $ 248.792. dollar compared to the eum.415. .767 $ 100. The difference is attributable to the accounting principle used by the company to value its non-U.259 $ 290.104.560 1.s cash flows from financing activities shows that the company reimbursed the totality of its short-term debt during fiscal year 2004 and had no short-term or long-term borrowing in 2005. The analysis of Rl.792.363 million less $417. dollar long-term debt.591 1.335 495. the company did not actually issue debt during that year.276.352 RL'S CASH FLOWS FROM FINANCING ACTIVITIES After accounting for the net cash outflow from investing activities.281 million in 2005).447 $ 1.8 Note that RL repurchased shares in fiscal year 2004 as well as in year 2005 ($40. which more than offset the drastic increase in the margin component of the net operating cash flow.608 million less $134. 8Although the balance sheets ending the fiscal year 2005 show an increase in the firm's long-term debt.708 Total capital employed $1.345 99. which is valued at "fair value." The increase reflects the depreciation of the U.

but also to allow the reimbursement of the company's short-term debt.281 million) allowed the firm to finance the difference as well as its finance-related activities. such as interest payments.250) 3.606 $352.317 $388.459) (174.608 $370. 2004 April 2.048) (134.138) (243. Net cash flow from financing activities Total net cash flow (A+B+ E.173 $ (1. Rl.608 million to $388.606 million) to the end of year 2005 ($350.840 (21.s cash position did not changed much from the end of fiscal year 2003 ($343. without reducing significantly its cash position (from $352.046 18.363 (126. In 2004.391) 2.839 (12. 2005 $244.485 $343.248) (417.729 (21. patterns of cash flows differed significantly from year 2004 to year 2005. Net cash flow from investing activities • Cash flows from financing activities Payment of dividends Repurchases of common stock Proceeds from the exercise of stock options Net payments of short-term debt Interest payments Others C.335 F. net of cash acquired Others B. . receipts from the exercice of stock options ($54. there were not enough internally generated funds for a large acquisition.C HAP T E R 4 Measuring Cash Flows 143 Fiscal year ended: • Cash flows from operating activities Margin component Investment component: (Increase) decrease in working capital requirement A.363 million).414 (100.000) 6. Closing cash (E + D) In total. In 2005.003 (80. essentially coming from improved operating margin.485 million).718) (1.047) 40. However. Net operating cash flow (NOCF) • Cash flows from investing activities Purchases of property and equipment.420) $ 8.052) 54.232) $223.847) (1. net Acquisitions.850) $352. However. Rl.485 million at the end of 2005).281 (6. despite a drastic increase in the net operating cash flow (from $223.335 $350.943) (10.s net operating cash flow was large enough to not only fund the firm's capital expenditures.335 million at the end of 2004 to $350.386) (14. Opening cash C) April 3.053 27.

040 .1 to measure the latter). What is the difference between this approach and the one in the cash-flow statement in the previous question? c.Test Problems 4. Constructing and interpreting cash-flow statements. What is the difference between this approach and the ones in the previous two questions? d. 11th ed.144 FINANCE FOR EXECUTIVES 1. Calculate net operating cash flow in 2004 and 2005. and Terry Warfield. The financial statements of Allied & Consolidated Clothier (ACC). 2. and Roman L. and balance sheets are dated December 31. Financial Accounting. ACC's operational efficiency and liquidity position are analyzed in Chapter 3. using earnings before interest and tax (EBIT). See Chapter 4. are shown below.1. All figures are in millions of dollars. South-Western. Donald. Intermediate Accounting. Jerry Weygandt. depreciation. See Chapters 5 and 7. using earnings before interest. Interpret your results. Stickney.040 ----- $880 $910 $1. b. Self. a manufacturer of coats and other garments. John Wiley & Sons. tax. lei!. Kieso. 2004. Prepare a standard cash-flow statement for the years 2004 and 2005. a. What are cash flows from assets in 2004 and 2005? What do they measure? Year Ended Cash Trade receivables Inventories Prepaid expenses Net fixed assets 2003 $100 200 160 30 390 2004 2005 Short-term debt Trade payables Accrued expenses Long-term debt Owners' equity Total liabilities & owners' equity 2003 $ 80 170 40 140 450 2004 2005 $ 90 $ 50 230 290 170 300 30 35 390 365 $ 90 $ 135 180 220 45 50 100 120 475 535 Total assets $880 $910 $1. Calculate net operating cash flow in 2004 and 2005. e. The income statements span a calendar year. Clyde P. and amortization (EBITDA). Calculate net operating cash flow as the difference between cash inflows from operations and cash outflows from operations (refer to Appendix 4. 2003.

and administrative Depreciation expenses • Earnings before interest Net interest expenses 2004 $1.160 200 55 $1. . What is the difference between this type of statement and the one prepared in question (a)? 4. Separate the margin component from the investment component in the net operating cash flow in 2004. Transactions.600 1. and 0 to indicate no effect.C HAP T E R 4 Measuring Cash Flows 145 2003 • Net sales Cost of goods sold Selling. Return to the 2003 and 2004 financial statements for Carrefour. Examining the operating cash flow of a retailer.to indicate a decrease."')'cash flow from financing activities (CFF1N) and owners' equity. in 2004 and 2005? How do they compare with net operating cash flows? What is the major weakness of this cash-flow measure? g. What can you conclude about Carrefour's growth strategy? Review Problems 1.2 of Chapter 3. Prepare a statement of cash flows (FASB 95) for 2004 and 2005.350 970 165 50 2005 $1. What are bankers' cash flows.2. the French retailer whose operational efficiency and liquidity positions are examined in problem 3. Separate the margin component from the investment component in the net operating cash flows in 2004 and 2005. Indicate the effect of the following transactions on working capital requirement (WCR).1Q $ $ 50 60 Dividends • Addition to retained earnings f. . What is the cash flow that Carrefour has generated from its operating activities in 2004? b. a.200 expenses 860 150 40 and tax (EBIT) 150 20 165 20 185 25 • Earnings before tax (EBT) Income tax expense • Earnings after tax (EAT) 130 40 $ $ $ 90 75 15 145 45 160 50 UQQ $ $ 75 25 1LJ. What can you conclude? h. general. net operating cash flow (CF OPE)' cash flow from investing activities (CFIJ'. Use + to indicate an increase. or cash earnings.

6. 4. Obsolete inventory is written off. and cash flows. Building a cash flow statement. The net operating cash flow (NOCF) d. Profits. 14. Minority interest in an firm is acquired for cash. Dividends from a subsidiary are received. 3. Based on the following financial statements and information given below. 12. 5. The cash outflow from operations c. 8. 3. losses. compute the following for the year 2004: a. Shares are issued for cash. Cash is obtained through a bank loan. 10. A fixed asset is depreciated.146 FINANCE FOR EXECUTIVES . Insurance premium is paid.. The total net cash flow . A cash dividend is paid. Merchandise is purchased on account. 13. How would you explain that a firm can generate a profit. Do you agree with the statement that depreciation expense is one of the firm's most important source of cash? 4. The cash inflow from operations b. The net cash flow from financing activities f. Accounts receivable are collected. Interest on debt is paid. a. Corporate income tax is paid. Goods from inventory are sold for cash. 7. 9. How would you explain that a firm showing a net loss can have a positive cash flow from operations? Depreciation and cash flows. The net cash flow from investing activities e. A fixed asset is sold for cash at a loss. 11. 2. 2. when at the same time its cash flow from operations is negative? b. WCR CFOPE CF1NV Owners' Equity 1.

000 $ 11. 3.000) $ 30.C HAP T E R 4 Measuring Cash Flows 147 2005 Net sales Cost of goods sold Material cost Labor expenses Selling.000) $224.000 $145.000 1. 4.000 36.000 38.000 $7.000 81.200 81. and administrative Depreciation expenses expenses $320. .400 38.200 $ 10.000 $165.000 (3.000 The firm is a distributor of video games for which you have the following information: 1. The company did not issue or repurchase any new shares in 2005.000 2.000 (260.500 32. 2. The balance of long-term debt was $27 million at the end of 2004. Prepaid expenses are prepaid rent and insurance premium.000 23.000 $ Accounts receivable Inventories Prepaid expenses Net fixed assets Total assets Short-term debt Accounts payable Accrued expenses Long-term debt Owners' equity Total liabilities and owners' equity 7. The company did not sell any fixed assets in 2005. of which $4 million was paid in 2005.000 25.000) (9.000 28. 2005.000 of taxes on December 15. The company paid in advance $10.800.000 $165.800) $ 19.000 $145.500 76.200 Earnings before interest and tax Net interest expenses Earnings before tax Income tax expense Earnings after tax Addition to retained earnings $ 9.000 (10.400 32.000 (18. 6.000 $ 9.000 4.000 91.000 30. The company owes its employees (direct labor force) $4 million at the end of 2004 and $2 million at the end of 2005. general.000) $ 33.000 2. 5.

200 5.410 3. the indirect approach to computing the net operating cash flow according to FASB 95. A year later it owed $5 million. 2005 S 330 4.200. general.595 $11.500 165 1. a. The company paid $9. The company owed $3 million short term to its bank at the end of 2004. Two cash-flow statements.760 286 1. 8.255 385 1. b.148 FINANCE FOR EXECUTIVES 7. 2004 December 31.300 4.829 $8. Prepare the company's cash flow statement for 2005 according to the direct method.485 286 1.199 473 $ Earnings before Interest and tax Net interest expenses Earnings before tax Income tax expense Earnings after tax Dividends 726 220 S Balance Sheet (in thousands) December 31.100 2.000 of dividends in 2005. The company borrowed $6 million long term in 2005.620 4. .745 Total assets Short-term debt Accounts payable Accrued expenses long-term debt Owners' equity 1.745 S 2.730 Cash Accounts receivable Inventories Prepaid expenses Net fixed assets' S 385 3.430 $8.760 27.275 Total liabilities and owners' equity 'The company did not sell any fixed assets in year 2005. 9.520 o o 1.610 5.335 $11. Below are the income statement for 2005 and the balance sheets at year-end 2004 and 2005 of Allied Enterprises Inc. Prepare the managerial balance sheets of Allied at year-end 2004 and 2005. and administrative Depreciation expenses expenses $34.275 S 570 1. 5. Income Statement (in thousandsl 2005 Net sales Cost of goods sold Selling.

What would make this version of the cash-flow statement a relevant one? . net Net cash provided by (used in) financing activities Net (decrease) increase in cash Cash and cash equivalents. Direct versus indirect approach to cash-flow estimation. What are the major differences between the cash-flow statement (direct method) and the statement of cash flows (indirect method according to FASB 95)? Which is the most relevant to financial analysis? 8.II A PT E R 4 Measuring Cash Flows 149 6.705 241.278) 420. in problem 5 that measures the firm's cash flow from its operating activities in 2005 from its cash flows that the firm was legally obliged to meet that year (nondiscretionary cash flows) and from those cash flows that were at the discretion of the management (discretionary cash flows).548 Cash flows from investing activities Purchases of property and equipment Purchases of short-term investments Net cash used in investing activities Cash flows from financing activities Payments of long-term debt Proceeds from the exercise of stock option Short-term bank borrowings (repayments).732) (27. The interest payments in 2004 were equal to $28. Another version of the cash-flow statement. Build a cash-flow statement for Allied Enterprises Inc.190 (19. beginning of period Cash and cash equivalents. From the following cash-flow statement of Tommy Hilfiger Corporation build the firm's cash-flow statement according to the direct method.328) (152.826 $414.857 (56.152 109. Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities Net cash provided by operating activities $132. end of period 7.729 million.051) 8.946) (163. From the statement of cash flows (FASB 95) to the cash-flow statement (direct approach).807) (6.596) (84.

of the operating cycle on the firm's Below are the last three years' financial statements of Sentec Inc.100 5000 150 1.090 430 660 200 S S Balance Sheets (in thousands) December 31.050 350 1. December 31. general. What accounts for the change in the firm's net operating cash flow over the two-year period? .600 25.000 100 900 130 770 310 460 200 $ 2005 $31.300 0 1.. The effect of the management cash flows.200 0 1.950 December 31. and administrative expenses Depreciation expenses Earnings before interest and tax Net interest expenses Earnings before tax income tax expense Earnings after tax Dividends S 180 $22.750 100 650 110 540 220 S 2004 $24.900 2.950 S 500 1.150 FINANCE FOR EXECUTIVES 9. Income Statements (in thousands) 2003 Net sales Cost of goods sold Selling. and 2005. 2004.730 2.100 4.300 19.350 260 1.300 4.200 4. a distributor of electrical fixtures. Prepare Sentec lnc.400 200 1.250 S 1.200 4. 2005 S 300 4.100 3.600 260 1.200 $7.330 $10.450 S 600 2.390 $7. 2004 S 350 3. Prepare Sentec's cash-flow statements for years 2004 and 2005 according to the direct approach.300 4.800 0 1. 2003.300 $7.850 $10. b.'s managerial balance sheets on December 31.100 17.330 S 300 1.600 3.130 $7. 2003 Cash Accounts receivable inventories Prepaid expenses Net fixed assets Total assets Short-term debt Accounts payable Accrued expenses Lonq-term debt Owners' equity Total liabilities and owners' equity 'The company cfld not sell any fixed assets in years 2004 and 2005. c.250 a.

an average payment period of 33 days.834 1.110 $ 50 98 800 $ 880 1. Suppose that Sentec Inc. general.554 44 62 23 $ 32 5 $13.912 2.514 $4.671 1.230 $ Accounts payable Accrued expenses Long-term debt Owners' equity Total liabilities and owners' equity 1.450 50 1.925 55 90 44 $ 66 44 $11. 2004 Cash Accounts receivable Inventories Prepaid expenses Net fixed assets Total assets Short-term debt December 2004 30. what would its working capital requirement have been? Its net operating cash flow in year 2005? 10. In 2005.720 9. had managed its operating cycle like the average firm in the sector. Below are the semi-annual financial statements of the company for the last year and a half. and administrative Depreciation expenses Interest expenses Corporate income tax Earnings after tax expenses $10. June 30. a large manufacturer of electrical and electronics products for consumer and institutional markets.694 42 818 $6. and an inventory turnover of eight.C HAP T E R 4 Measuring Cash Flows 1 51 d. 2005.110 'The firm did not sell any fixed assets over the three-year period.940 1.912 $ 60 $ 70 2.'s had an average collection period of 30 days.085 25 830 $5. Mars Electronics is a distributor for the Global Electric Company (GEC).536 $6. firms in the same business sector as Sentec Inc. Net sales Cost of goods sold Selling. On December 31.650 138 700 2. Seasonal business.572 $5. 2005 $ 160 1.100 2.986 80 733 $4.677 76 70 26 $ 37 Dividends to be paid $ $ $ June 30.655 8. .230 2.851 11.950 114 750 2.616 2.953 1.

and June 30. Prepare Mars Electronics' cash flow statements according to the direct method for the six months ending June 30. 2004. What accounts three periods? for the changes in the firm's cash flows over the . b.152 FINANCE FOR EXECUTIVES a. December 31.2004. 2005.

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